Oil Will Be Expensive Again – The Future Of Oil Prices And How We Risk To Get It Wrong Again

Many people comment on low oil prices nowadays. At the 2015 Spring Meeting of the World Bank and the International Monetary Fund too experts discussed the issue of falling prices and their implications. However, we should be wary of taking these discussions too seriously. Sure, oil prices are low and there are good reasons why they should stay low. However, if there is one proven fact of the history of oil prices forecasting then it is that such forecasting is almost always wrong. While oil prices are low at the moment, therefore, we should not take this for granted for the coming years.

At the 2015 Spring Meeting of the World Bank/International Monetary Fund as well as on many other occasions, experts, politicians and others have discussed falling oil prices. Indeed, the oil price has fallen tremendously throughout recent months (see chart below). Reading recent comments on the oil market, one might indeed get the impression that low oil prices might stay with us for a very long time. At the IMF Meeting, for example, the Kazakh Minister of National Economy Erbolat Dossaev expressed his hope that oil prices might stabilize at $US 60 by 2019. Low oil prices for many years!

Low oil prices are an important issue…

A lot of developments speak in favor of low prices. Apart from the already ample supply, for example, talks with Iran might boost investment into the country’s oil industry, resent advances against ISIS might help Iraqi production, and states such as Venezuela or Nigeria might opt to increase income by maximizing oil output. Moreover, the effects of falling oil prices are substantial. For oil exporters, falling prices mean decreasing state income. Particularly in oil states that are heavily reliant on such income to finance a variety of subsidies, this might put substantial pressure on governments. Importing economies, on the other hand, save money that might now be invested in other projects. Oil prices are also important for climate policy and renewable energy, since fossil energy prices are key to the opportunity costs of sustainable energy investments – in the case of oil this is particularly apparent in the area of electromobility. It is, in other words, legitimate and important to discuss falling oil prices and their effects.

…but they won’t last forever!

Nevertheless, we should not trust current price levels too much. History has proven that long-term oil price expectations are normally proven wrong by actual developments. Indeed, also at the IMF meeting, the President of Goldwyn Global Strategies, David L. Goldwyn, cautioned against low prices in the long term. “This is a price cycle”, so he argued, “and it will not last.” When thinking about rising oil prices over the coming two to five years, one should take into account some weak signals and wild cards that might send prices up. In the following, I have tried to collect some of these.

Weak Signals

We should be aware of taking low oil prices for granted in the medium or long term. We already see weak signals for future upward oil price pressure:

More importantly, low oil prices make investment in costlier production capacity less attractive. Much of today’s new capacity comes from costlier resources such as shale oil, oil sands, or deep water offshore, for example in the Arctic region and at the Brazilian coast. In the calculation of products, project developers will have to prove the viability of their projects at much lower oil prices.

Oil companies are furthermore suffering from low oil prices, which substantially lower their profit margins. They need to cut cost, for example by reducing work force, reducing financing for education and R&D. Just as it happened in the early 2000s, we might soon encounter a situation in which demand picks up but supply response is hampered by severe bottlenecks in the value and production chain of the oil industry – including a lack of qualified engineers, exploration equipment and technology necessary for efficient production.

Moreover, economic sanctions against Russia and its main oil firm Rosnef have severely complicated the financing of future oil production in Russia. This will most likely have a mid-term effect on Russian oil production.

It also remains to be seen how the US shale gas sector, characterized by the activity of many small firms, responds to low oil prices. Small firms are much more dependent on external financing. Moreover, shale production normally has a lifetime much shorter than larger oil fields – one needs to drill more and more frequently. As a consequence, investment decisions need to be taken more frequently. Although the shale industry has significantly increased efficiency and lowered prices, it is not clear how it will react to low prices and the expectation of low prices in the long run (for an estimate of break even prices in the industry see chart above).

Wild Cards

Wild cards are events that are less likely to happen, but would have tremendous effects on oil prices. They are low probability, high impact. Some wild cards remain possible that might send oil prices up much more rapidly in the future.

The most apparent wild card is a large scale conflict in the Middle East. Particularly the current situation in Yemen could lead to an increasing confrontation between Saudi-Arabia and Iran. While conflict has a much more extreme effect on oil prices when markets are tight, a large scale confrontation that involves Saudi-Arabia might have such effects even in the current situation.

Another wild card concerns a rapid decline of the US-Dollar. Although there is not much talk about US economic problems at the moment, the problem of national debt is far from resolved. A debt crisis gone astray would probably result in a devaluation of the US-Dollar. Since most oil is still traded on the basis of the US-Dollar while being consumed in other regions, a significant Dollar devaluation would certainly result in a rise of oil prices.

Finally, a renewed global economic crisis remains a possibility. There has been recurrent talk, for example, about problems in the Chinese banking sector. The effect of such a Chinese banking crisis and its ripple on effects on oil prices would most likely be complicated. A prolonged economic crisis would result in reduced demand and thus falling prices. However, as we have seen in 2008, the initial effect of a financial crisis might be reverse. When the US housing bubble burst in 2007, economic turbulence might have been foreseen. In the short term, however, another effect of the burst was more important: Investors that anticipated falling notations for most investment products were searching for alternative investment opportunities. They found these opportunities in commodity markets and particularly in oil futures. Thus, even after (or more precisely: because) financial markets suffered substantial contraction and when economic performance began to slide, oil prices shot up to more than $US 140.

This list is by no means complete. One might add more arguments for medium- and long-term higher oil prices. Even in its incompleteness, however, it shows that low oil prices are not necessarily here to stay. Author: Jörn RichertFigure I: Own graph, data from eia.gov.Figure II: Bloomberg New Energy Finance.